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March 31, 2006

Factoring: Jet fuel for attracting packagers

This financing tactic may be new to co-packers, but it works in other industries. It speeds up cash flow—and growth—key selling points with purchasing managers.Key termsFactoring: Factoring: A form of short-term financing that provides funding to companies relative to the quality and quantity of their sales, or accounts receivable. The funding comes in the form of either a purchase or a loan against the company’s eligible receivables.Factor: A company that provides factoring services.

For any contract packager all areas of the company must grow in sync to assure success. But for a young fast-growing co-packer it is not uncommon for sales production operations customer service and finance to grow out of alignment.

The effect is that operations at an unbalanced co-packer’s facilities may begin to tilt. The time spent making corrections can distract from healthy growth—and may even jeopardize new business if purchasing managers at consumer packaged goods companies (CPGs) assess that a co-packer can’t handle their packaging project.

Adequate financing is the underlying solution. A number of financing options are available to meet the above-stated challenges but one method that may be worth a closer look for maturing contract packagers is called factoring. Although young fast-growing companies in other industries have successfully used factoring to accelerate their businesses this financing tactic seems to be little known in contract packaging circles.

In simplest terms factoring is a form of short-term financing that provides funding to companies relative to the quality and quantity of their sales or accounts receivable. The funding comes in the form of a purchase against the company’s eligible receivables.

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Factoring can accelerate a contract packager’s cash flow over the short term to help sustain growth and to keep the growth balanced. At the same time evidence of a factoring relationship can provide a purchasing manager at a CPG evidence of a co-packer that is on solid financial footing—one key consideration in the purchasing manager’s qualifying process. That insight might give one co-packer an edge over a competitor when the purchasing manager makes the service-purchase decision.

When used under suitable circumstances factoring accelerates cash flow stabilizes it and makes it predictable. Factoring enables growing companies to realign their corporate focus from scrambling for cash flow to diversifying their capabilities. For example a contract packager can leverage the funds tied up in its accounts receivable to support and sustain growth. Factoring does not create debt so it comes with fewer restrictions and covenants than debt financing. In addition equity participation is avoided making ownership dilution and profit sharing non-issues.

Best prospects for factoring

Factoring is available for contract packagers from start-up firms to those with $100 million in annual revenues. (However most firms with greater than $20 million in annual revenues are best suited for traditional forms of finance.) It is ideally suited for co-packers experiencing rapid growth because the availability of funds is limited only by the growth of sales. Factoring serves as a financial incubator for companies that are not yet ready for traditional finance relationships with banks and other lenders. Most companies that have opted for factoring as a financial tool have tended to use it for one to two years before migrating to traditional financing.

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What are some conditions that make factoring attractive for contract packagers? Consider that traditional cash-flow management solutions are debt and equity financing. Banks and Small Business Association lenders offer businesses a low-cost debt form of working capital. However for an early-stage contract packaging firm with few assets for collateral and a weak statement of cash flows this type of financing is usually unobtainable limited or available only on terms that are undesirable to the co-packer. Equity financing options such as venture capital offer a cash-based solution if they can be found. However these options usually require the contract packager to surrender partial ownership and a share of profits in exchange for the investment.

Factoring can be ideal for contract packagers with:

· The need for working capital to support operations required for revenue growth (e.g. product development equipment purchases payroll accounts payable).

· Periodic cash flow pressure due to seasonal demand or unexpected sales experienced more than two or three times per year.

· No desire to possess traditional bank credit lines to support operational growth.

· The need for accelerated receipt of outstanding invoices.

· The desire to take advantage of trade discounts or other long-term sensible financial investments.

· Strong sales opportunities that require capital.

How factoring works

Let’s look at a simple example to explain how factoring works.

Consider a contract packaging company that has just delivered $10 of packaged goods to a medical products customer. Instead of waiting out the typical payment period which could be 90 days or more the contract packager sells the $10 invoice to a factor a company that provides the service. The factor in turn advances the company 75% of the invoice—$7—within 24 hours. The contract packager can use the cash however it sees fit to expand its business. Once the medical products customer decides to pay the $10 invoice it sends the payment to the factor. The factor then retains its original advance of $7 plus a factoring fee (typically about 4% of the face value of this invoice—in this example it would be $400)—and returns the remaining balance—$2—to the contract packager.

By leveraging the capital tied up in unpaid accounts receivable contract packagers can:

Think of adequate financing as jet fuel. The key to being in a good factoring relationship rests with the ability to take advantage of accelerated cash flow to support growth.

Slow accounts receivable turnover is one case in point. A contract packager specializing in dairy food packaging was facing a hard decision. One of its largest customers was demanding an additional 30 days to pay on its account. This contract packager feared that its once loyal customer would jump ship for a competitor. It wanted to do everything possible to accommodate the customer.

However the extension of terms meant the contract packager would be hard-pressed for cash in order to meet its recently expanded payroll. By electing to factor the contract packager made cash available that had been tied up in its accounts receivable. As a result payroll and other expenses were timely met and the contract packager was able to accommodate its most profitable customer.

The challenges associated with growing too quickly serve as another example where factoring may make sense to contract packagers. Consider the case of a newly developed tamper-proof vial attracting more customers than a contract packager can handle. However the contract packager sunk all of its investment capital into research and development as well as equipment purchases.

The sudden surge of orders for the new vials was a disaster in the making when it should have been cause for celebration for this emerging firm. The co-packer needed cash desperately to replenish inventory and increase production or it would have to turn away orders for the vials.

Having been rejected for a traditional bank loan this contract packager turned to factoring to get the capital it needed to keep growing. Knowing that the financing would now grow in line with its sales the co-packer built a solid customer base for the vials. In less than a year the co-packer’s financial position was strong enough to attract competitive terms from the same bank that had earlier rejected its request for financing. The growth that the co-packer sustained due to factoring later enabled it to easily migrate into a traditional banking relationship.

Getting started

The search for a factor should start either on the Internet or in the local Yellow Pages. Search under factors factoring and/or commercial finance. Not all factors are created equal. They differ in terms of the industries they serve their appetite for risk the structure of their programs etc. so contract packagers should use caution in assessing the capabilities of each factor on their target list.

It’s best to educate yourself by talking to a few factors to get a sense of what is available. Look for a structure that is simple and feels comfortable. Don’t be overly focused on the least expensive price. Weigh the trade-offs between price and a user-friendly structure.

Factoring is not Camelot but when used under the right conditions it can provide a very good short-term financing solution to accelerate a contract packager’s cash flow and growth.

The author Peter Aransky is regional vice president at The Hamilton Group a Syracuse NY-based factoring firm specializing in financing small- to mid-sized businesses. Contact Peter at 877/272-6759 or [email protected].